401k Loan Question

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401k Loan Question

Postby br214bh » Wed May 22, 2013 5:53 pm

Hi All,
I have been browsing several posts on 401k loans and haven't really received a straight answer on my question, so here it is:

If you are taking a 15k loan at 4.25% interest on a 401k, are you physically removing that value out of your investment options?
If so, as you pay back your loan, is the loan principal and the loan interest (less a tax deduction on the interest), then applied back into your investment options with each payment?

With both those being true then although a PRO is that during the loan you are 'loaning' money to yourself and paying yourself the interest, a definite CON is that while that money is loaned it is not appreciating with your other 401k investments.

Assuming that the money you loan is used in an investment that appreciates faster (for the hypothetical assume it was guaranteed to) than the 401k investment appreciation (accounting for the expense ratios) during the period of the loan, this is would be a 'better investment', correct?

Thanks in advance for helping me think through this. Also, I am looking at this is a hypothetical and taking out the emotional side of borrowing from retirement money and assuming no risk in loss of employment relating to any risk of default.
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Re: 401k Loan Question

Postby FNK » Wed May 22, 2013 6:01 pm

Your understanding is correct, except there is no tax deduction on the interest. Also:

1) You're removing the risk of the 401(k) investments and replacing it with risk of your own investments. If your investment is, say, a mortgage paydown, it may be considered risk-free.

2) The interest you pay into the plan is taxed on withdrawal. There are mind-boggling arguments on whether it amounts to double taxation, but it's definitely a disadvantage compared to a mortgage deduction.
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Re: 401k Loan Question

Postby IlliniDave » Wed May 22, 2013 6:17 pm

Yes, at least with my employer's plan that is how it works. You would see your account value go down once the loan is processed and the payments are added back in one at a time.

The bigger risk than the lost opportunity cost during payback is what you mention at the end. Under those conditions the loan is due immediately (~30 days) and whatever's not repaid by then is subject to income tax and possibly penalty tax.

The final question is more difficult. If it all worked out according to the happy path the earnings you lose in the 401 would have continued to grow tax free for possibly decades. Tax can be a much bigger bite out of the alternate investment than the expense ratios. In theory you could posit some return rate that would make you come out ahead (ignoring risks). Remember to compare the scenario to buying the alternate investment at whatever time the loan would be paid back, 3 years or whatever, and leaving your 401k alone.

Not knowing the specifics, all I can say is it would have to be a pretty big difference in payoff before I'd even consider it.
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Re: 401k Loan Question

Postby livesoft » Wed May 22, 2013 6:32 pm

FNK wrote:Your understanding is correct, except there is no tax deduction on the interest.

I will guess that the OP meant taxes are taken out before the interest is paid. So if one has to pay $75 of interest and one is in the 25% tax bracket, then more than $100 of gross pay is needed before taxes to get the $75 that would go towards interest.
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: 401k Loan Question

Postby livesoft » Wed May 22, 2013 7:44 pm

br214bh wrote:Assuming that the money you loan is used in an investment that appreciates faster (for the hypothetical assume it was guaranteed to) than the 401k investment appreciation (accounting for the expense ratios) during the period of the loan, this is would be a 'better investment', correct?

Correct. Let me give a specific example: Suppose you have a high-fee 401(k) where they give you Vanguard Total Bond Index but add a 2% annual fee for their generosity. You can borrow from the 401(k) and buy Vanguard Total Bond Index in a 529 plan with only a small fee. You save 2% annually in fees on the outstanding loan balance and the gains on the 529 are tax-free.

Since my example uses identical funds in both accounts, no one should have any quibbles with it.
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: 401k Loan Question

Postby FNK » Thu May 23, 2013 6:28 pm

livesoft wrote:Since my example uses identical funds in both accounts, no one should have any quibbles with it.


This. Is. Bogleheads.

Of course we'll find quibbles.

401(k) loans usually have associated fees.
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